The US housing market has not hit bottom and, depending on which view you take, has quite some room to move down further. The truth is that we are still in the middle of a historic crash. However, as with such market dislocations, there are very attractive opportunities to invest and make profits if one has capital, patience, expertise, and a good plan in place.

Iâ€™ve pulled together some very compelling data from a myriad of sources including G7 Capital Management, a private equity firm specializing in distressed real estate. Itâ€™s using this data that Iâ€™ll lay out exactly why I feel the people that are calling for a bottom are the soon-to-be victims of a massive head fake; why the nightmare has a long way to go; and how you might be able to profit from it.

Why Everyone Is Wrong â€“ This Isnâ€™t a Bottom

There are four items in place that are tricking people into calling a bottom, when in fact three of these items are temporary. The result is an artificial restriction of supply and artificial pumping of demand.

1) Itâ€™s the seasonally strongest buying season
2) Thereâ€™s a foreclosure moratorium about to end
3) Federal tax credits offered for 1st time homebuyers
4) Historically low mortgage rates (this may or may not change soon)

Why More Foreclosures Are Coming â€“ A Lot More

Foreclosures will continue to come as long as the job market does not get better. Also, borrowers who have Alt-A loan products will have those coming due in the next couple of years and many of the loans will not qualify for the current values resulting in their homes being foreclosed on. The result is that the market will be flooded with new supply, and without artificially increased demand, prices will continue to drop. Hereâ€™s why:

1) We have rising unemployment and a worsening economy.

2) Banks hold massive number of future foreclosures due to the moratorium. The moratorium will end and those houses will hit the market. In the California market, where G7 is concentrating its purchases, the numbers are devastating.

3) April was highest month for foreclosure since records were kept by Realtytrac.

4) 1/3 of all properties for sale are REOâ€™s, or bank-owned real estate.

This last item is key. According to ForeclosureRadar.com and Field Check Group, there are 911,000 Notices of Default (NODs). These people are living in their houses, for free, waiting for the axe. Of these, 393,000 have been foreclosed. Of the 393,000 foreclosures, 118,000 are unsold REO’s. Backing out the 393,000 from the 911,000 total, the remaining 565,000 homes represent potential foreclosures and short sales. That means 683,000 total potential REO and Short Sales coming to market.

What kinds of foreclosures have occurred thus far and will occur going forward? So far, speculators and those with subprime mortgages are the ones who have been taken out. Coming up, G7 expects to see those with Alt A, or Pay Option loans going under, along with Prime and Jumbo loans that are defaulting due to job losses and general price declines. These Jumbo, or non-conforming loans, are a major factor for banks, since they must put that loan on their balance sheet since there is no securitization market. Therefore, banks are being extremely tight in underwriting these loans, making these homes harder to purchase, further increasing supply.

As the more expensive homes begin to default, that will put pricing pressure on that sector, with declines of 20% – 25% expected. As those homes decline in price, the homes in the price tranche just below those will feel the pressure and decline as well. G7 expects declines in the Conforming mortgage pool to decline 7% – 10%, while the median is anticipated to drop 10% – 15% (the median is a tricky statistic though as it may not drop as much if higher priced homes begin to work through the system).

The bottom line here is clear: tons of housing supply coming to market.

So how can you profit?

A Generational Low in the Making

The first thing to do is figure out where the worst declines are coming. According to Zillow.com Q4-2008 Real Estate Market Report. Moody’s Economy.com, First American CoreLogic, and T2 Partners Estimates, it’s the boom areas that are in major trouble: The percentage of mortgages that are underwater is staggering. Here’s the top four: Miami (65.1%), San Diego (63.9%), Las Vegas (61.4%), and Los Angeles (56.4%).

The numbers could, believe it or not, be even worse. This data does not include the roughly 50% of Alt-A and subprime loans that were cash0out refinances that now carry a higher loan balance than original purchase amount. Whoa!

The next issue to look at is timing. Moody’s Economy.com shows that the median price index for single family homes has crashed way below the trendline, and hasn’t bottomed yet.

So now is the time to be gathering capital and as those foreclosures start to hit, you’ll want to judiciously deploy it into those properties.

Now this is all well and good, but given how awful this crash is, how do we know the market will recover, and when will that happen? I can’t predict the future, but there are some extremely compelling trends that tell us this situation is akin to what savvy investors saw with the old Resolution Trust Corporation.

U.S. Housing Starts from 1959 to the present, are at their lowest point in fifty year — below 500,000. It’s been said that the “smart money” gets into housing when new starts drop below one million. Meanwhile, because of these price declines, housing affordability is — believe it or not — at unprecedented highs in California.

With so few new starts, once this excess inventory comes online and Americans start snapping up the bargains, it’s reasonable to assume that housing at the bottom end of the market has limited downside.

And finally, the price-to-rent ratio has reached a point where properties can be rented at rates that not only cover principal, interest, and taxes, but can actually generate cash flow above and beyond those requirements and still have room for future price appreciation.

So How Do You Profit?

There are a few places to fish to take advantage of these trends, depending on how you see things playing out. One school of thought says that all those people being foreclosed on will have to live somewhere, and that may mean that apartment buildings see higher demand. But you’d be barking up the wrong tree. Apartment rental rates are going down. More likely, people who need a house to live in and get foreclosed upon still need a house to live in. So house rental rates will be fine. In that case apartment REITs in the big housing bubble cities might be one thing to short. Some of these include Avalonbay Communities (AVB), Home Properties (HME), and Equity Residential (EQR).

I think you still want to avoid, or even short, retail REITs. Consumer spending isn’t recovering, and when foreclosures slam neighborhoods, businesses in those neighborhoods will be further harmed. General Growth Properties just filed for bankruptcy. I’d stay away from Glimcher Realty Trust (GRT), but Getty Realty Corp might be fine, as it deals in gas stations and convenience stores. There will still be demand for these, and their latest financials look okay. It pays a 10% yield.

What to do about the homebuilders? Companies like Pulte (PHM), Toll Brothers (TOL), D.R.Horton (DHI), KB Home (KBH), Lennar (LEN), and NVR (NVR) will see their fortunes rise again one day. Sooner or later, all that excess foreclosed inventory is going to be chewed through. About 300,000 homes get demolished each year. I don’t quite think we’ve hit the bottom here yet, but I would start to keep an eye on these players. Choose the ones with the strongest balance sheets and operate in regions that are the least badly hit by foreclosures.

As for those individual homes that are being foreclosed upon, I think those offer the biggest opportunity for capital appreciation. Of course, you really have to know what you’re doing, and buying into those wacky do-it-yourself infomercials on how to buy a foreclosed home isn’t the best way. You need to know where and when to fish for homes, and it isnâ€™t easy. It goes beyond just grabbing any old foreclosure. You need sophisticated data and analytics. You need plenty of capital to get significant discounts from current values. The home that needs fixing up is worth more in the long run….and you canâ€™t even get loans for homes that need to be fixed up. The best bet is for accredited investors to seek out private equity funds who have a plan or, for those individuals who want to own a few homes of their own the G-7 Realty has a program where they will help you locate, finance, acquire, rehab and rent the home and later tell you when is the appropriate time to sell.

If you are interested in seeing charts associated with this article, please visit here.

Full Disclosure: No position in any stocks mentioned.

If you’d like to contact me, you may do so at pdlcapital@earthlink.net

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